ABCs of 401(k)s

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Retirement is one of the topics that we get asked about most frequently. It’s kind of like taking your vitamins – you know it’s good for you, but you only feel the benefits much later on.

This, coupled with the fact that many millennials are determined to retire early, is why we are here to break down the foundations of one of the most common retirement solutions in the United States: 401(k) plans.

First things first – why is it called a “401(k)”?

To confuse and intimidate you, and discourage you from making contributions to your account.
Just kidding – 401(k)s are named after the section of the tax code that governs them.

Where did they come from?

401(k) plans originated in the 1980s. Before this, employers typically provided pension plans, which paid out a steady stream of money over the course of your retirement. The key difference here is that in a 401(k) plan, you are setting aside your own money for retirement, whereas with a pension fund, the company pays you. See the difference? These days, a few industries still have pension funds, notably: education, government, and some unions.

In the United States, the employer-employee relationship has changed drastically over the last 60 years. The idea that your job is a second home, and that your employer “takes care” of you, is long gone. You can say that this change is at the center of one of the great divides of our times: boomers vs. millennials. Back in the day, companies were expected to take care of employees well into retirement, and provide a livable stipend for them into their old age. Isn’t that a quaint concept?

These days, if you want to retire and maintain a similar quality of life you enjoyed while employed, it’s on you to make that happen. That’s why contributing to a retirement plan is critical.

How do I get a 401(k) plan?

401(k) plans are employer-sponsored, meaning that it is something that your job chooses to offer you. If your employer does not offer a 401(k) plan do not worry – you can still save for retirement via IRAs (we will cover this topic in a subsequent post).

Anything else I should know?

Most companies let you contribute to your 401(k) right away, however some make you wait a certain amount of time. In my own humble opinion, companies that make you wait 1 year or more to contribute are not doing right by you, and are prioritizing short-term interest (i.e. greed) over your financial well-being. You can (and should) do better than this.

Even when you leave an employer – your 401(k) remains yours. It doesn’t disappear one day without telling you, like that one ex we don’t talk about any more. Also, you don’t pay taxes on money you put into your plan until you withdraw.

If / when you do switch jobs, don’t forget to roll over your 401(k) – it helps to have them in one place, rather than having 5 different plans with 5 different administrators, making it difficult to keep track.

Why should I even contribute to my 401(k)? I need the money now, not when I’m 65.

Oh ye of little faith – OH YE OF LITTLE FAITH! There’s so many reasons why you should contribute to your 401(k).

  • Like we said in our previous post, you’re going to need a lot more money than you think to live comfortably in retirement.
  • Because $1 today is worth more than $1 tomorrow, each dollar you put into your plan now will compound into a lot more dollars day by day, year over year.
  • Contributions to your 401(k) are deducted from your pre-tax income, which helps you pay less in taxes. Think about it – if your paycheck is $100, and you contribute $5 per paycheck to your retirement, you are taxed on $95, not $100.
  • Even if your company goes under, your 401(k) is safe – any money you allocate to a 401(k) is yours forever.
  • Avoid cashing out early. Barring extreme life events, cashing withdrawing early from your 401(k) will result in you paying not only a 10% early withdrawal fee, but also an additional 25% in income taxes. Not to mention, you’ll be missing out on that sweet compounded growth.

Like we alluded to earlier, the employer-employee relationship in the United States these days is very transactional. By contributing to your 401(k), you are safe-guarding your financial future and making an investment in the most important thing – yourself.

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